Chapter 7

Decentralization and Pricing

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Chapter Outline
Learning Objectives
 Compute a target cost when the market determines a
product price.
• Compute a target selling price using cost-plus
pricing.
• Use time-and-material pricing to determine the cost
of services provided.
• Determine a transfer price using the negotiated,
cost-based, and market-based approaches.

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Target Costing

Compute a target cost when the market determines a

product price.

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Target Costing
The price of a good or service is affected by many factors.
• Company must have a good understanding of market
forces.
• Where products are not easily differentiated from
competitor goods, prices are not set by the company, but
rather by the laws of supply and demand – such
companies are called price takers.
• Where products are unique or clearly distinguishable
from competitor goods, prices are set by the company.

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Target Costing
Establishing a Target Cost

• Laws of supply and demand significantly affect product

price.
• To earn a profit, companies must focus on controlling
costs.
• Requires setting a target cost that will provide the
company’s desired profit.

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Establishing a Target Cost
Target cost as related to price and profit
• Target cost: Cost that provides the desired profit when
the market determines a product’s price.

Market Price − Desired Profit = Target Cost

• If a company can reach it’s sales targets, produce its

product for the target cost or less, it will meet its profit
goal.

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Establishing a Target Cost
Other considerations
• First, company should identify the segment of the market
where it wants to compete.
• Second, company conducts market research to determine the
target price – the price the company believes will place it in
the optimal position for the target consumers.
• Third, company determines its target cost by setting a
desired profit.
• Last, company assembles a team to develop a product to
meet the company’s goals.

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DO IT! 1: Target Costing
Fine Line Phones is considering introducing a fashion cover for its
phones. Market research indicates that 200,000 units can be sold if the
price is no more than $20. If Fine Line decides to produce the covers, it
will need to invest $1,000,000 in new production equipment. Fine Line
requires a minimum rate of return of 25% on all investments. Determine
the target cost per unit for the cover.
The desired profit for this new product line is
$1,000,000 × 25% = $250,000
Each cover must result in profit of $250,000 ÷ 200,000 units = $1.25
Market price  Desired profit = Target cost per unit
$20  $1.25  $18.75 per unit
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Cost-Plus and Variable-Cost Pricing

Compute a target selling price using cost-plus pricing.

Cost-Plus Pricing
• In an environment with little or no competition, a company
may have to set its own price.
• When a company sets price, the price is normally a function
of product cost: cost-plus pricing.
• Approach requires establishing a cost base and adding a
markup to determine a target selling price.

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Cost-Plus Pricing
Relation of markup to cost and selling price
Selling Price − Cost = Markup (Profit)
• In determining the proper markup, a company must
consider competitive and market conditions.
• Size of the markup (the “plus”) depends on the desired
return on investment for the product:
ROI = net income ÷ invested assets
Cost + Markup = Target Selling Price

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Cost-Plus Pricing Variable cost per unit
Illustration: Thinkmore Products, Inc. is in the process of setting a
selling price on its new video camera pen. It is a functioning pen
that will record up to 2 hours of audio and video. The per unit
variable cost estimates for the new video camera pen are as follows.

Per Unit
Direct materials $23
Direct labor 17
Variable manufacturing overhead 12
Variable selling and administrative expenses 8
Variable cost per unit $60

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Cost-Plus Pricing
Fixed cost per unit, 10,000 units
In addition, Thinkmore has the following fixed costs per
unit at a budgeted sales volume of 10,000 units.

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Cost-Plus Pricing
Calculation of markup and selling price
Thinkmore has decided to price its new video camera pen to earn a 20%
return on its investment (ROI) of $2,000,000. double underline

Expected income = 20% ROI of $2,000,000

Desired ROI = $400,000 ÷ 10,000 units = $40
Per Unit
Sales price
per unit = Variable cost $60
Fixed costs 65
Total cost 125
Markup (desired ROI per unit) 40
Selling price per unit (at 10,000 units) $ 165

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Cost-Plus Pricing
Computation of markup percentage
Use markup on cost to set a selling price:
• Compute the markup percentage to achieve a desired ROI of $40
per unit:
Markup (Desired ROI Total Markup
 
per Unit) Unit Cost Percentage
$40  $125  32%

• Compute the target selling price:

Target
Total  Total Markup 
  Unit Cost  Percentage   Selling Price
Unit Cost  
per Unit
$125  ($125  32%)  $165

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Cost-Plus Pricing
Limitations of Cost-Plus Pricing
• Advantage of cost-plus pricing: Easy to compute.
• Disadvantages:
o Does not consider demand side:
• Will the customer pay the price?
o Fixed cost per unit changes with change in sales volume:
• At lower sales volume, company must charge higher
price to meet desired ROI.

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Limitations of Cost-Plus Pricing
Fixed cost per unit, 5,000 units
Illustration: If budgeted sales volume for Thinkmore’s
Products was 5,000 instead of 10,000, Think more’s variable
cost per unit would remain the same. However, the fixed cost
per unit would change as follows.

Thinkmore's desired 20% ROI now results in a $80 ROI per

unit [(20% × $2,000,000) ÷ 5,000].

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Limitations of Cost-Plus Pricing
Computation of selling price, 5,000 units
Thinkmore computes the selling price at 5,000 units as follows.
Per Unit
Variable cost $60
Fixed costs 130
Total cost 190
Markup (desired ROI per unit) 80
Selling price per unit (at 5,000 units) $ 270

At 5,000 units, how much would Thinkmore mark up its total unit costs to
earn a desired ROI of $80 per unit.
$80 (desired ROI per unit)
 42.11%
$190 (total unit cost)
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Cost-Plus Pricing
Question

a. Selling price = variable cost + (markup percentage +

variable cost).
b. Selling price = cost + (markup percentage × cost).
c. Selling price = manufacturing cost + (markup
percentage + manufacturing cost).
d. Selling price = fixed cost + (markup percentage ×
fixed cost).

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Cost-Plus Pricing
Answer
a. Selling price = variable cost + (markup percentage +
variable cost).
b. Answer: Selling price = cost + (markup percentage ×
cost).
c. Selling price = manufacturing cost + (markup
percentage + manufacturing cost).
d. Selling price = fixed cost + (markup percentage ×
fixed cost).

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Variable-Cost Pricing
Alternative pricing approach:
Simply add a markup to variable costs.
• Avoids the problem of uncertain cost information related to
fixed-cost-per-unit computations.
• Helpful in pricing special orders or when excess capacity
exists.
Major disadvantage is that managers may set the price too
low and fail to cover fixed costs.

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DO IT! 2: Target Selling Price
Air Corporation produces air purifiers. The following per
unit cost information is available: direct materials $16,
direct labor $18, variable manufacturing overhead $11,
variable selling and administrative expenses $6. Fixed
selling and administrative expenses are $50,000, and fixed
manufacturing overhead is $150,000.
Using a 45% markup percentage on total per unit cost and
assuming 10,000 units, compute the target selling price.

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DO IT! 2: Target Selling Price
Solution
Compute the target selling price.
Direct materials $16
Direct labor 18
Variable manufacturing overhead 11
Variable selling and administrative expenses 6
Fixed selling and administrative expenses 5
Fixed manufacturing overhead 15
Total unit cost $ 70

Total  Total Markup  Target Selling

+   
Unit Cost  Unit Cost Percentage  Price per Unite
$71 + ($71  45%)  $102.95

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Transfer Prices

Determine a transfer price using the negotiated, cost-

based, and market-based approaches.
Vertically integrated companies
• Grow in either direction of its suppliers or its customers.
• Frequently transfer goods to other divisions as well as
outside customers.

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Transfer Prices
Transfer pricing example

How do you price goods “sold” within the company?

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Transfer Prices
Three possible approaches
Transfer price - price used to record the transfer between two
divisions of a company.
• Ways to determine a transfer price:

1. Negotiated transfer prices.

2. Cost-based transfer prices.
3. Market-based transfer prices.
• Conceptually - a negotiated transfer price is best.
• Due to practical considerations, companies often use the other two
methods.
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Negotiated Transfer Prices
Illustration: Alberta Company makes rubber soles for work &
hiking boots.
• Two Divisions:
o Sole Division - sells soles externally.
o Boot Division - makes leather uppers for hiking boots
which are attached to purchased soles.
• Division managers compensated on division profitability.
• Management now wants Sole Division to provide at least
some soles to the Boot Division.
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Negotiated Transfer Prices
Computation of cont. margin for two divisions
Computation of contribution margin per unit for each division
when Boot Division purchases soles from an outside supplier.

“What would be a fair transfer price if the Sole Division sold

10,000 soles to the Boot Division?”
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Negotiated Transfer Prices
No Excess Capacity

• If Sole sells to Boot,

o payment must at least cover variable cost per unit plus
o lost contribution margin per sole (opportunity cost).
• The minimum transfer price acceptable to Sole is:

Variable Opportunity Minimum

 
Cost Cost Transfer Price
$11  $7  $18
Negotiated Transfer Prices
Transfer price negotiations - no excess capacity

The most Boot Division (the buyer) will pay is what the
sole would cost from an outside supplier.

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Negotiated Transfer Prices
Excess Capacity

• Can produce 80,000 soles, but can sell only 70,000.

• Available capacity of 10,000 soles.
• Contribution margin of $7 per unit is not lost.
• Minimum transfer price acceptable to Sole:

Variable Opportunity Minimum

 
Cost Cost Transfer Price
$11  $0  $11

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Negotiated Transfer Prices
Transfer pricing negotiations - excess capacity
In this case, the Boot Division and the Sole Division should
negotiate a transfer price within the range of $11 to $17.

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Negotiated Transfer Prices
Variable Costs

• In the minimum transfer price formula, variable cost is

the variable cost of units sold internally.
• May differ - higher or lower - for units sold internally
versus those sold externally.
• The minimum transfer pricing formula can still be used
– just use the internal variable costs.

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Negotiated Transfer Prices
Summary

• Transfer prices established:

o Minimum by selling division.
o Maximum by the purchasing division.
• Often not used because:
o Market price information sometimes not easily obtainable.
o Lack of trust between the two divisions.
o Different pricing strategies between divisions.

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Cost-Based Transfer Prices
• Uses costs incurred by division producing the goods as its
foundation.
• May be based on variable costs alone or on variable costs
plus fixed costs.
• Selling division may also add markup.
• Can result in improper transfer prices causing:
o Loss of profitability for company.
o Unfair evaluation of division performance.

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Cost-Based Transfer Prices
Cost-based transfer price - 10,000 units
Illustration: Alberta Company requires the division to use a
transfer price based on the variable cost of the sole. With no
excess capacity, contribution margins per unit for the two
divisions are:
Cost-based transfer price—10,000 units

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Cost-Based Transfer Prices
Conclusions
• Cost-based pricing is bad deal for Sole Division – no
profit on transfer of 10,000 soles to Boot Division and
loses profit of $70,000 on external sales.
• Boot Division is very happy; increases contribution
margin by $6 per sole.
• If Sole Division has excess capacity, the division reports
a zero profit on these 10,000 units and the Boot
Division gains $6 per unit.

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Cost-Based Transfer Prices
Cost-based transfer price results
• Overall, the Company is worse off by $10,000.

• Does not reflect the division’s true profitability nor

provide adequate incentive for the division to control
costs.
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Market-Based Transfer Prices
• Based on existing market prices of competing goods.
• Often considered best approach because it is objective
and generally provides the proper economic incentives.
• It is indifferent between selling internally and externally
if can charge/pay market price.
• Can lead to bad decisions if have excess capacity.
• Why? No opportunity cost.
• Where there is not a well-defined market price,
companies use cost-based systems.
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